In my view, there are three potential outcomes to the current correction. I’ll give a brief overview of my thoughts here and go into more depth in our quarterly newsletter that comes out in October.
The Base Case—Stagnation
My base case is we don’t head into recession, economic activity actually picks up in the second half of the year, the better news lifts stocks prices which manage modest gains for the year, and we go into a sideways trading range sometime after January of 2012.
The market recoups its losses because it has priced in a recession that doesn’t happen and at a price to earnings ratio of just above 12, the market is historically undervalued. However, due to wrong-headed economic policies, the economy has anemic growth for the following 1-2 years.
In this scenario, good asset allocation with good investments would likely be wise.
The Bear Case—Mild Recession
In this scenario, the increased volatility of the markets reduces consumption and Europe’s woes continue to plague investor confidence reducing economic activity and we “slip” into recession.
We would likely see a rebound from the current correction, only to slip below the August 8th low as measured by the S&P 500. The market might languish for a while. Since the market has most likely already priced in a recession, further market downside might be limited.
In this scenario, it is possible that our WealthProtect System (our proprietary trend following system) would signal an exit from equities, but this would likely require either a sharp reduction in corporate earnings or further downside in the market.
The Nightmare Case—Depression
The nightmare case is that we have a repeat of 2008 in Europe that spreads globally. Socialist policies in Europe and the failure of Keynesian stimulus at home combine to form a toxic combination that has us slide into a depression (remember the Great Depression was actually two recessions separated by a short recovery).
I find this case very scary, but also very unlikely for a number of reasons. Things are rarely as bad as they seem at the time; a number of factors that existed in the Great Depressions such as untimely interest rate hikes and a trade war don’t exist now.
Still, the results for the markets would be harsh with another slide in equities likely. Unless the slide was to happen very quickly a la 1987, I expect our WealthProtect System would likely trigger in an attempt to limit the downside risk.
Some may wonder where is my bull case. Sorry, from an economic perspective we need changes at the top that emphasize economic growth: lower tax rates—especially for corporations, reduced regulations to enhance capital formation, and simply getting out of the way of business would do wonders. Until that happens, don’t expect miracles.
Keep in mind, however, these are just opinions. The markets can still potentially do well in our base case because of easy monetary conditions and an undervalued equity market, especially if investors anticipate electoral changes in 2012.
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult with your financial advisor. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. No strategy assures success or protects against loss. Stock investing involves risk including loss of principal.